Part 1. The Demand for Health: Theoretical Underpinnings and Empirical Results

Introduction to Part 1



I



n the fall of 1966, Gary S. Becker was a member of a National Bureau of

Economic Research (NBER) staff reading committee that reviewed a paper

titled “The Production of Health: An Exploratory Study,” by Richard Auster,

Irving Leveson, and Deborah Sarachek. Gary’s main comment on the paper

was that it ignored that what people demand when they purchase medical

care services are not these services per se but rather good health. The latter

item enters the utility functions of consumers, and medical care is only one of

many inputs into its production. He proceeded to specify a demand function for

health whose arguments included the prices of health inputs, the efficiency of

the production process as reflected by the number of years of formal schooling

completed by the consumer, and income or, more precisely, the exogenous

components of income.

When Gary wrote his review, I had just entered my third year in the PhD

program in economics at Columbia University. He was a professor of economics at that university as well as an NBER research associate. I had completed

all the courses and examinations and was searching for a dissertation topic.

I also was working as a research assistant to Victor R. Fuchs at the NBER. Victor had encouraged me to select a topic in health economics for my dissertation.

I had consulted Gary about a topic, but he had not worked in health economics



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and did not have any suggestions. His review changed all that. After Gary finished it, he gave it to me and said that it contained an idea for a PhD dissertation. Originally, it was supposed to be a study of the effects of education on

health, but along the way he encouraged (some might say demanded) me to

broaden it into a theoretical and empirical analysis of the demand for health.

It is not surprising that Gary emphasized the difference between health as

an output that enters the utility function and medical care as one of a number of

inputs into its production in his review. After all, he had published his seminal

paper titled “A Theory of the Allocation of Time” in the Economic Journal the

previous year (Becker 1965). In that paper, he developed the household production function model of consumer behavior by drawing a distinction between fundamental objects of choice (called commodities) that enter the utility function

and market goods and services. Consumers produce commodities with inputs

of market goods and services and their own time. Because goods and services

are inputs into the production of commodities, the demand for these goods and

services is a derived demand for a factor of production. Although most of the

applications in his paper pertain to extensions of labor supply theory, Gary could

easily have titled it “The Household Production Approach to Consumer Behavior” or “On the New Theory of Consumer Behavior” because the applications

extended far beyond labor supply. Indeed, he published a paper with the latter

title in the Swedish Journal of Economics in 1973 (Michael and Becker 1973).

In my dissertation (Grossman 1970) and the publications that resulted from

it (Grossman 1972a, 1972b), I use the household production function approach

as one of two building blocks to construct a model of the demand for health. I

assume that consumers demand health, defined broadly to include illness-free

days in a given year and life expectancy, and produce it with inputs of medical

care services, diet, other market goods and services, and their own time. Hence,

the demand for medical care and other health inputs is derived from the basic

demand for health.

My second building block, also due to Gary, is the theory of investment in

human capital (for example, Becker 1964). Health, like knowledge, is a durable

capital stock; and both may be viewed as components of the stock of human capital.

Consumers have incentives to invest in this stock in the present because it increases

their earnings in the future. Indeed, in his Economic Journal paper, Gary pointed

out that investment in human capital is a prominent use of a portion of the time

allocated to nonmarket or household production. I proceeded to pursue a distinction

between the returns to an investment in knowledge and the returns to an investment

in health that he suggested to me. To be specific, investments in knowledge raise

wage rates and investments in health raise the total amount of time available for

market and household production in a given year and prolong length of life.1



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The first paper in this section contains most of the theory in my dissertation. It

appeared in the 1972 volume of the Journal of Political Economy with the title “On

the Concept of Health Capital and the Demand for Health.” It is my first publication

of original material and is my most widely cited one. In the paper, I first develop a

general model of the demand for health, which contains both an investment motive

and a consumption motive for increasing the stock of health. I then focus on a pure

investment model in which the consumption benefits of health are small enough

to be ignored. I do so to contrast health capital with other forms of human capital

and because the pure investment model generates powerful predictions from simple analyses. Moreover, the consumption aspects of the demand for health can be

incorporated into empirical estimation without much loss in generality.

The other paper in this section is my contribution to Volume 1A of the

Handbook of Health Economics, published by Elsevier (Grossman 2000).

I include it as a substitute for my 1972 monograph titled The Demand for

Health: A Theoretical and Empirical Investigation, published by the NBER.2

The monograph and the paper spell out the differences between a pure investment

model of the demand for health and a pure consumption model in which the

investment returns are small enough to be ignored. The paper also summarizes

the main empirical results in the 1972 monograph. In addition, because the paper

was published almost three decades after the monograph, some extensions of

the theoretical and empirical work in the monograph and some criticisms of the

framework as of the late 1990s are discussed.

I would be remiss if I did not indicate the fate of the paper by Auster, Leveson, and Sarachek that led Gary Becker to suggest the topic of my PhD dissertation to me. I am delighted to report that it was published in an early volume

of the Journal of Human Resources (Auster, Leveson, and Sarachek 1969). The

authors concluded that the rate of return to investing in health by increasing

education far exceeded the rate of return to investment in health by increasing

medical care. That conclusion was responsible, in part, for the subsequent literature that has investigated whether more schooling causes better health. That

issue serves as the subject of part 2 of this book.



NOTES

1. In the introductions and afterwords to the first two parts of this book, I refer to forms of

human capital other than health capital as knowledge capital, which is most commonly

measured at the empirical level by completed years of formal schooling.

2. I am very pleased that Columbia University Press, which distributed the monograph for

the NBER, is reissuing the monograph as a companion to this book.



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REFERENCES

Auster, Richard, Irving Leveson, and Deborah Sarachek. 1969. “The Production of Health:

An Exploratory Study.” Journal of Human Resources 4(4): 411–436.

Becker, Gary S. 1964. Human Capital. New York: Columbia University Press for the National

Bureau of Economic Research.

Becker, Gary S. 1965. “A Theory of the Allocation of Time.” The Economic Journal 75(299):

493–517.

Grossman, Michael. 1970. “The Demand for Health: A Theoretical and Empirical Investigation.” PhD Dissertation, New York: Columbia University.

——. 1972a. “On the Concept of Health Capital and the Demand for Health.” Journal of

Political Economy 80(2): 223–255.

——. 1972b. The Demand for Health: A Theoretical and Empirical Investigation. New York:

Columbia University Press for the National Bureau of Economic Research.

——. 2000. “The Human Capital Model.” In Handbook of Health Economics, Volume 1A,

ed. Anthony J. Culyer and Joseph P. Newhouse. Amsterdam: Elsevier Science B.V.,

North-Holland Publishing, 347–408.

Michael, Robert T., and Gary S. Becker. 1973. “On the New Theory of Consumer Behavior.”

Swedish Journal of Economics 75(4): 378–396.



On the Concept of Health Capital



ONE



and the Demand for Health

Michael Grossman



ABSTRACT



The aim of this study is to construct a model of the demand for the commodity “good health.” The central proposition of the model is that health can be

viewed as a durable capital stock that produces an output of healthy time. It is

assumed that individuals inherit an initial stock of health that depreciates with

age and can be increased by investment. In this framework, the “shadow price”

of health depends on many other variables besides the price of medical care.

It is shown that the shadow price rises with age if the rate of depreciation on

the stock of health rises over the life cycle and falls with education if more educated people are more efficient producers of health. Of particular importance is

the conclusion that, under certain conditions, an increase in the shadow price

may simultaneously reduce the quantity of health demanded and increase the

quantity of medical care demanded.



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1. INTRODUCTION



During the past two decades, the notion that individuals invest in themselves

has become widely accepted in economics. At a conceptual level, increases in a

person’s stock of knowledge or human capital are assumed to raise his productivity in the market sector of the economy, where he produces money earnings,

and in the nonmarket or household sector, where he produces commodities

that enter his utility function. To realize potential gains in productivity, individuals have an incentive to invest in formal schooling or on-the-job training.

The costs of these investments include direct outlays on market goods and the

opportunity cost of the time that must be withdrawn from competing uses. This

framework has been used by Gary Becker (1967) and by Yoram Ben-Porath

(1967) to develop models that determine the optimal quantity of investment

in human capital at any age. In addition, these models show how the optimal

quantity varies over the life cycle of an individual and among individuals of

the same age.

Although several writers have suggested that health can be viewed as one

form of human capital (Mushkin 1962, 129–149; Becker 1964, 33–36; Fuchs

1966, 90–91), no one has constructed a model of the demand for health capital

itself. If increases in the stock of health simply increased wage rates, such a task

would not be necessary, for one could simply apply Becker’s and Ben-Porath’s

models to study the decision to invest in health. This paper argues, however,

that health capital differs from other forms of human capital. In particular, it

argues that a person’s stock of knowledge affects his market and nonmarket productivity, while his stock of health determines the total amount of time he can

spend producing money earnings and commodities. The fundamental difference

between the two types of capital is the basic justification for the model of the

demand for health that is presented in the paper.

A second justification for the model is that most students of medical economics have long realized that what consumers demand when they purchase

medical services are not these services per se, but “good health.” Given that

the basic demand is for good health, it seems logical to study the demand for

medical care by first constructing a model of the demand for health itself.

Since, however, traditional demand theory assumes that goods and services

purchased in the market enter consumers’ utility functions, economists have

emphasized the demand for medical care at the expense of the demand for

health. Fortunately, a new approach to consumer behavior draws a sharp distinction between fundamental objects of choice—called “commodities”—

and market goods (Becker 1965; Lancaster 1966; Muth 1966; Michael 1972;

Becker and Michael 1970; Ghez 1970). Thus, it serves as the point of departure